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Basics of Financial Investing – Part 13

Potentially Useful Timing Rules

The preceding discussion may or may not be helpful to those seeking to apply market timing to the management of their portfolio. It should at a minimum help you understand why the market is doing what it is doing. Now let’s turn to some potentially helpful timing rules. Don’t get too excited. Most of these rules tend to work only in special circumstances and provide only a minor benefit. Still, some advantage is better than no advantage and a lot better than false promises that can lead you astray.

Take tax losses by November in order to avoid the depressing impact of tax-selling in December

A substantial body of research has been devoted to what has come to be known as the January effect. According to these studies, stocks that had been depressed at year-end tend to rebound in January. Stocks whose prices are depressed in December may be beaten down by tax-selling. Investors often seek to reduce their tax liability by realizing losses before the calendar year ends. Indeed, they may be selling their losers to such an extent that the selling pressure pushes the relevant (already depressed) stock prices down even more. After the year ends, the selling pressure abates and the stocks that had been depressed by tax-selling may rebound somewhat.

Harvesting tax losses is often advantageous. An investment that is not working out as planned can at least be sold to realize a capital loss and thereby offset the tax liabilities on more successful transactions. If the stock is never destined to recover, the tax shelter provided by the tax loss is the only thing that is left to be salvaged. Taking losses sooner rather than later has the effect of accelerating the realizations of the tax benefit. One does not, however, want to exacerbate the pain by selling a losing position at the very bottom. Since most tax-selling tends to occur in the latter part of December, one who realizes losses earlier in the year is less likely to be selling during a period of heavy selling pressure (and therefore at especially depressed prices).

Normally you can wait as late as November to realize your tax losses and still not get hit by the adverse effect of tax-selling. Alternatively, you can wait until January to do your selling, when the price may have rebounded somewhat. Waiting until January, however, pushes the tax benefit into the next year. You would generally prefer to realize the tax benefit before year end. That way you can use the realized loss to reduce your tax liability a year sooner.

When possible, avoid realizing gains late in the year. Postpone realizing those gains until the next calendar year in order to put off the tax liability

For almost all taxpayers, December 31 is at the dividing line between events that lead to a tax liability in the current year and those that relate to taxes for the next tax year. Just as realizing losses in time to use them to reduce the current year’s tax liability is generally advantageous, so is postponing gains realizations and the corresponding tax liability into the following year. One who might otherwise sell a gain-bearing position late in the current year could benefit tax-wise by deferring the transaction until the beginning of the following year. A gain realized in the last part of the current year will generally require a corresponding estimated tax payment on January 15 or, at a minimum, a tax payment on April 15 of the following year. That same gain realized in the first part of the following year will, at worst, result in an obligation to make four equal-sized tax payments starting with April and extending up to the following January. Thus by deferring the transaction into the following year, the tax liability is put off by an average of at least six months and typically more. Deferring a tax liability has the same financial impact as getting an interest-free loan from the government.

Options can be used both to protect a gain and to defer realizing it in order thereby to put off its associated tax liability

Waiting until after January 1 to realize a gain exposes you to the risk that the market will move adversely before your position is liquidated. Your stock’s price could decline while you wait for the year to turn. Several different techniques may be used to postpone a gain’s realization while simultaneously protecting the gain itself. One such profit-protecting approach utilizes options.

Suppose you would like to realize the gain on a stock at the current price level. You bought the stock at 15 and it currently trades at 53. Your gain of 38 points per share will, if realized, give rise to a substantial tax liability. If you had owned 500 shares, your gain would be $19,000, and even at 15 percent the tax liability would amount to $2,850. If the gain is short-term and you are in the 35 percent tax bracket, the associated tax liability would amount to $6,650. You want to lock in your gain now but postpone incurring your tax liability until next year. This objective can be accomplished (with some risk of not succeeding) by writing an in-the-money call or (with no risk of failure) by buying a put. You could, for example, write a call with a strike of 50 that expires in January. If the stock’s price remains above 50 when the option expires, the call would be exercised. You would sell your stock to the one who owns the call. The stock now priced at 53 has a reasonably good chance of staying above 50 until next year. The odds of an exercise would be even more in your favor if you wrote the call with a strike of 45 or 40. The lower the strike, however, the smaller the time value on the call that you write. This in-the-money call-writing strategy has the added bonus of obtaining a somewhat higher price for your position than an outright sale (the previously mentioned time value of the option). That is, you might be able to sell a three-month call with a strike of 50 on a 53 dollar stock for a price of 5. You would be paid immediately for the call and then receive the strike price for your stock when (if) the option was exercised. So, you would be paid 5 now and (hopefully) 50 later, for total sale proceeds of 55 for a stock now selling at 53 (assuming the stock’s price stayed above 50 so that the option was exercised). You might even receive an additional dividend by holding the stock a bit longer.

You could also protect your gain by purchasing a put. A put with a strike of 50 would cost you something and protect you only against a stock price fall of greater than 3 points. Still, you would retain the benefit of any price rise in the stock as you waited for the year end to arrive.

Another way to defer a gain is to sell short against the box

Rather than use options, you could defer but lock in your gain by selling short against the box. With this procedure, you would sell short an amount of the stock equivalent to the amount that you own. But you would not initially use your long position to cover your short position. As a result, your account would reflect both a long and a short position involving equal amounts of the same stock. Once the year ended, you would use your existing long position to cover your short position. Your taxable gain would thereby be assigned to the new year. One disadvantage of this strategy: You do not obtain access to the short sales’ balance until the short position is closed. That is, even though you have essentially sold your stock, the sales proceeds will remain deposited in your short account until you actually cover your short position. And your broker will probably keep any interest earned on this short balance.

Use options to realize a loss and yet maintain your position

Suppose you show a paper loss (unrealized) on an investment. You would like to realize this loss so that you can use it to lower your tax liability this year. You would also like to hold on to your position because you expect the price on the losing position to rebound. If you realize a loss but restore your position within thirty-one days (buying back either after or before the sale), the set of transactions would be viewed by the IRS as a wash sale. You are not allowed to recognize such a wash sale loss on your tax returns. Rather, the loss on your position becomes embedded in the basis of your restored position in the repurchased stock.

Options can, however, be used to avoid the adverse impact of the wash sale rule. One approach would be to sell the stock and simultaneously buy a call on the stock. As long as the call has an expiration date that is more than thirty days off, you can use it to buy the stock back without fear that the price will rise above the call’s strike price. Moreover, if the stock’s price declines below the strike price, you can buy the stock back on the market for less than your calls’ strike price.

A second approach is to sell your stock at a loss and then write a deep in-the-money put on the same stock with an expiration date more than a month off. If the put is exercised, you will own the stock again. With this put strategy, you actually pick up some time value as opposed to paying for it with the purchase of a call. You will also have some temporary cash that you can use (invest it for a return or use it to pay down debt and thereby reduce the interest cost). The one risk with this strategy is the possibility that the stock price will rise above the put’s strike price. But, if you write a put that is deeply in the money and has a short expiration, this risk is likely to be small.

Be mindful of the ‘‘Cockroach Rule’’

Suppose you have the misfortune to walk into the kitchen, turn on the light, and see a cockroach scamper across the floor. You can be almost certain that you are sharing your living space with more than one cockroach. You saw the one that happened to be out and about. The others were not visible, but they certainly were hiding there someplace.

A similar kind of phenomenon often occurs when a stock that you have the misfortune to own releases very bad news, particularly when the news is truly awful. A company that begins to release news of a serious nature often tries to let its investors down slowly. Management is only now being forced to face up to reality. Only now is the company beginning to reveal just how bad things are. The first announcement of trouble may put an unrealistically favorable spin on the situation. But the bad news continues to come out. Things go from bad, to worse, to disastrous. We saw this phenomenon with both WorldCom and Enron. Accounting irregularities were discovered and disclosed. Then more and still more. The poor investor could not get a sense of where the bottom was because more bad news kept coming out. The result was horrendous. Not only was the released news very bad in and of itself, but also each new release contradicted things said in the last. The market soon lost all faith in each company’s credibility.

The point for the investor is clear: Bad news, truly bad news, is often followed by still worse news. If you own stock in a company that is beginning to disclose very bad news, you may be inclined to hang in there and wait for things to turn around. That strategy will sometimes work. But the wait may be long and difficult. Think about the cockroach theory.

The market generally rises in a presidential election year

Every four years (every leap year) we have a presidential election. Almost always the current president is either seeking reelection or supporting his or her party’s nominee (often the current vice president). History has shown that if the economy is doing well, the party in power is usually reelected (Clinton, Reagan, Bush II), and it usually loses if the economy is thought to be doing poorly (Carter, Ford, Bush I). Accordingly, the administration currently in power would very much prefer for the economy to be strong and even improving going into the election. The government has a number of ways to influence the level of economic activity. Government spending and taxing (fiscal policy), Federal Reserve activity (monetary policy), activity in the international area (trade policy) and in the regulatory sphere (microeconomic policy) are all within the province of the federal government. The president has varying degrees of influence over the government’s economic policy. The president can be expected to pursue policies designed to bulk up a weak economy or maintain the strength of a strong economy as the election approaches. On the other hand, the Fed may worry that too much fiscal stimulation may overheat the economy. Too much steam in the economy leads to shortages, bottlenecks, and eventually inflationary pressures. Sometimes the Fed’s effort to fight inflation results in an economic slowdown just before an election (1960, 1992).

Most of the time, however, the economy is strengthening as a presidential election approaches

A strong economy does not necessarily translate into a strong stock market and vice versa. Still, in most presidential election years, we have seen the president’s administration take action to stimulate the economy. This economic stimulation has also tended to help the stock market.

On more than a few occasions, economic stimulation prior to an election has ended up overheating the economy. When that happens, inflation rears its ugly head. Then the Fed feels the need to slow things down. Tight monetary policy leads to rising interest rates and falling stock and bond prices. The period after a presidential election is not always favorable for the financial markets, particularly if the economy has been overheated prior to the election.

The stock market prefers Republicans

While the electorate is about evenly split between Republicans, Democrats, and independents, investors and business managers are disproportionately Republicans. Republicans tend to favor lower taxes and less government involvement in the economy. Most investors and managers have incomes and wealth levels that are well above those of average non-investors. Such higher net worth individuals generally believe that they will be better off economically under the kind of policies that Republicans tend to support. As a result of the above considerations, the market generally reacts more favorably in the period immediately after an election (presidential or midterm) in which Republicans do well than in elections in which Democrats do better than expected. This impact is, however, very short run. Soon after the election, the market will turn its attention to other matters.

Republicans and Democrats prefer policies that tend to favor different industries. Invest accordingly

The policies pursued by Republicans tend to favor one group of industries while those pursued by the Democrats tend to favor others. For example, Republicans are generally more supportive of defense spending than are Democrats. On the other hand, Democrats tend to be more supportive of environmental issues. Thus, pollution control and alternative energy–related companies are likely to fare better under Democrats. Democrats would spend more public money on health care (universal health insurance), but would also be more inclined to put controls on its pricing (pharmaceutical prices). Industries such as timber, oil, and tobacco tend to perform better with Republicans. High-tech industries tend to be more favorably disposed toward the Democrats. Republicans tend to favor lowering trade restrictions (free trade) while Democrats are more inclined to resist the lowering of trade barriers. They would prefer to protect American (particularly union) jobs, even at the cost of higher prices on goods and services for consumers. Investors should be mindful of the preferences of the two parties and the impact these preferences may have on particular companies and industries. Especially when a change of administration occurs, the impact (favorable or unfavorable) on various industries can be substantial.


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